Earnout Modeling in M&A Deals and Merger Models

In this tutorial, you’ll learn how and why earn-outs are used in M&A deals, how they appear on the 3 financial statements, and how they impact the transaction assumptions and combined financial statements in a merger model.

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Table of Contents:

1:28 What Earn-Outs Are and Why You Use Them

7:46 How Earn-Outs Show Up on the 3 Statements

12:21 How Earn-Outs Impact Purchase Price Allocation and Sources & Uses

16:02 How Earn-Outs Affect the IS, BS, and CFS in a Merger Model

19:12 Recap and Summary

What Earn-Outs Are and Why You Use Them

Instead of paying for a company 100% upfront, the buyer offers to pay some portion of the price later on – if certain conditions are met.

Example: “We’ll pay you $100 million for your company now, and if you achieve EBITDA of $20 million in 2 years, we’ll pay you an additional $50 million then.”

Earn-outs are VERY common for private company / start-up acquisitions in tech, biotech, pharmaceuticals, and related “high-risk industries.”

EA acquired PopCap for $750 million upfront, and offered an earn-out that varied based on PopCap Games’ cumulative EBIT over the next 2 years. The schedule was as follows:

2-Year Earnings Under $91 Million: Nothing
2-Year Earnings Above $110 Million: $100 million
2-Year Earnings Above $200 Million: $175 million
2-Year Earnings Above $343 Million: $550 million

Why Use an Earn-Out?

You see them most often when the buyer and the seller disagree on the seller’s value or expected financial performance in the future.

Earn-outs are a way for the buyer and seller to compromise and say, “We don’t really know how we’ll perform in the future, but if we reach a target of $X in revenue or EBITDA, you’ll pay us more for our company.”

The buyer will almost always want to base the earn-out on the seller’s standalone Net Income, while the seller prefers to base it on revenue, partially so the seller can spend a silly amount to reach these revenue targets.

As a compromise, EBIT or EBITDA are sometimes used.

How Earn-Outs Show Up on the 3 Statements

Balance Sheet: Earn-Outs are recorded as “Contingent Consideration,” a Liability on the L&E side.

Income Statement: You record changes in the value of the Contingent Consideration here, i.e. if the probability of paying out the earn-out changes, you show it as a Loss or Gain here. It’s a Loss if the probability of paying the earn-out increases, and a Gain if the probability decreases.

Cash Flow Statement: When the earn-out is paid out in cash to the seller, it’s a cash outflow here. You also have to add back or subtract changes in the Contingent Consideration value here, reversing what is listed on the Income Statement.

How Earn-Outs Impact Purchase Price Allocation and Sources & Uses

Earn-outs do not affect the Sources & Uses schedule for the initial transaction since no cash is paid out yet.

Earn-outs increase the amount of Goodwill created in an M&A deal because they boost the Liabilities side of the Balance Sheet, which, in turn, requires higher Goodwill on the Assets side to balance it.

How Earn-Outs Affect the IS, BS, and CFS in a Merger Model

You tend to leave the Income Statement impact blank in a merger model unless you have detailed estimates for the seller’s future performance.

You SHOULD factor in the cash payout of the earn-out on the combined Cash Flow Statement – you can assume a 100% chance of payout, or some lower probability.

The payout will appear in Cash Flow from Financing and reduce cash flow and the company’s cash balance.

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